“History is a nightmare from which I am trying to awake” -James Joyce[/b]
There have been numerous reserve currencies over the centuries, but none more widely accepted than the US dollar is, since 1944. While the US dollar has fluctuated widely in value over the 65 years since its designation as the reserve currency, its credibility has never come under such intense scrutiny ever as in the last few years.
The numerous factors which play in favor of the dollar as the appropriate choice include its size, quality and stability of the dollar asset markets, particularly the short term government securities market where the central banks tend to be the most active. The high liquidity of these financial markets makes the dollar an excellent medium for exchange.
The history of the US Dollar as the choice of the reserve currency dates back to the year 1944 near the end of the World War II. There was a vacuum created in World financial system after WW II due to weak position of pound sterling. With the world economy and the international economic and financial systems in near shambles, delegates from all 44 allied nations gathered in Bretton Woods, New York with an aim of setting up a system of rules, procedures and institutions to regulate the international monetary system. There the US Dollar took over the role that pound sterling/gold had played in the previous international financial system.
In 1971, the Bretton Woods System was revoked by USA. The amount of gold backing dollar have depreciated to low levels. USA felt that many currencies in the world were undervalued at that point of time. No other currency emerged as alternate reserve currency then. Japan was riding on huge current account balance. Although the German mark had a reputation as one of the world's most stable currencies, its contribution in the world economic affairs was not overwhelming. French Franc was also not that strong to play as reserve currency at that point of time. The Swiss Franc was based on a full gold convertibility until 2000. So after a brief marriage with Smithsonian agreement, the world moved on to free float economy and dollar remained as dominant currency in the world market.
The demand of dollar was artificially inflated after the collapse of Bretton woods system. USA made good use of its relations with Saudi Arabia, one of the largest oil producers. It supported the power of the House of Saud in exchange for accepting only U.S. dollars for its oil in 1972-73, just after the collapse of the Bretton Woods arrangement. Saudi Arab received military cover and legitimacy of monarchy in exchange. The rest of OPEC soon followed suit. As everybody in the world needed oil, they had to hold dollars. As the demand of oil was increasing at ever increasing prices, the demand of dollar can only increase. Thus oil became one of the most important strategies in the USA policy. Until recently oil could only be bought and sold in dollars (except from 2008 at Kish, Iran), thus inflating the demand of dollar. So after the earlier system of exchanging dollar to gold (Bretton Woods System) was now changed to dollar exchange to oil. USA has never taken any challenge to its oil policy lightly.
Mr. Saddam Hussein is said to have planned to sell oil in non-dollar currencies during 2002. Suddenly biological weapons were said to be present in Iraq and war was imposed on her. It is another fact that these biological weapons and “weapons of mass destruction” were never ever unearthed there. Iran planned a new oil bourse which would trade in any currency way back in 2005. It finally opened in Feb 2008 after a lot of hiccups which were said to be externally influenced. Iran was also on the verge of war because it was said to be in process of manufacturing nuclear bombs.
Not very long in the future, all that may be history. The Independent reported confirmed talks between gulf Arab and Chinese sources in Hong Kong of oil trade in dollar denomination. Brazil has shown interest in collaborating in non-dollar oil payments, along with India.
The recent downturn has shown that we can’t have only one reserve currency. The size of USA economy has become relatively smaller to the amount of global balance it is expected to serve. Its trade deficit is continuously increasing. The US dollar peaked in value in 2000-2001 and has been in a significant decline ever since. There was a relatively brief period in 2008 when the dollar rebounded quite sharply due to the worldwide financial crisis. But since then, the dollar has resumed its long-term downtrend. There were voices which argue that it was excessive dependence on dollar which led to world being dragged into the mess created by USA financial sector. They said that another reserve currency was required to de-risk the world economy from another downturn.
Variation of dollar against various currencies
Data from http://www.measuringworth.com/ppowerus
While making a decision about the choice of a reserve currency there are four factors which are largely considered – share of world output and trade, macroeconomic stability, degree of financial market development and network externalities. There had been multifarious reserve currencies over the previous centuries and the dollar has fluctuated widely in the past 65 years also.
The shop till you drop attitude of Americans is showing signs of change with personal saving rate rising to about 7% from less than 1% a year before. With increase in savings, spending is less. As consumer spending accounts for 70% of USA spending, the economy is going to contract in short term due to increased saving rate. Leading economists call it “the paradox of saving”.
Dollar Value Chart
Data from http://www.measuringworth.com/ppowerus
The Commission of Experts of the UN General Assembly on Reforms of the International Monetary and Financial System, led by Joseph E. Stiglitz, has suggested a gradual move from the US dollar to the Special Drawing Rights (SDR’s). It wants to increase the share of SDRs in total international reserves in a gradual manner starting from an issue of $ 250 billion.
Hong Kong is issuing bonds denominated in renminbi. Countries are starting to use their currencies in mutual trade instead of dollar (China and Brazil). Thus USA would be having harder time financing its trade deficit. Would China be the next superpower? Only time would have a definite answer.
China was the first economy to pitch for the dollar’s replacement as the world’s reserve currency. “The stability of international financial system can’t hinge on the currency of one single country, even though it is the largest economy in the world” said Hua Ercheng, Chief Economist in Beijing at the China Construction Bank. However, the bigger question remains – which currency will be able to replace the mighty dollar as the currency reserve? China has been criticized roundly for handling of its own currency renminbi. Talks about the replacement of the dollar as the reserve currency had proliferated at the G-20 summit held in London in early April. Thereby nations such as Russia, France and Brazil had suggested that the US Dollar should be supplemented by the other major currencies as a shared reserve currency. President Dmitry Medvedev of Russia had also questioned the Future of the US Dollar as a global reserve currency and had said that using a mix of regional currencies would enable in making the world economy more stable.
This is similar to Special Drawing Rights (SDRs) created by International Monetary Fund in 1969 in an effort to stabilize the international foreign exchange system. The basic definition of SDRs given by the IMF is as follows - The SDR is an international reserve asset, created by the IMF in 1969 to supplement its member countries’ official reserves. Its value is based on a basket of four key international currencies – US Dollar, Euro, Yen and British Pound. The US Dollar itself makes up almost half of the value of the SDR. The exact amounts of currency making up SDRs are determined by the IMF Executive Board in accordance with the relative importance in international trade and finance every five years.
The IMF’s so-called special drawing rights could be used as the basis for a new currency. First Deputy Managing Director John Lipsky said “There are many, many attractions in the long run to such an outcome,” Lipsky told a panel discussing reserve currencies at the St. Petersburg International Economic Forum.
Arguments against making SDRs the world's reserve currency include the fact that the US dollar, the Euro and the Pound – which make up the large majority of SDRs – have all lost value since late 2007 when the recession began. Why replace a falling dollar by an index which so heavily includes the dollar? Also, SDRs do not contain the Chinese renminbi, Indian Rupee, Australian Dollar or Canadian Dollar, all of which are important benchmark or secondary global reserve currencies. However if the dollar is started to be replaced by SDR, then IMF nowhere has the financial prowess to grantee the exchange risk.
SDRs would have to be delinked from other currencies and issued by an international organization with equivalent authority to a central bank in order to become liquid enough to be used as a reserve. Russia has proposed several regional reserve currencies including the ruble as a part of the response to the global financial crisis. Dominique Strauss Kahn, MD of IMF said that remnimbi can be added in the future to the basket of currencies of SDR So “This is not a quick, short or easy decision,” said Mr. Lipsky, adding that it would be “quite revolutionary.”
The status of the dollar as the reserve currency may also be challenged by the euro, the other global currency. It has equivalent advantages and fewer risks offered against the dollar. The euro area does not have a large current account deficit as a whole (although Germany has a large surplus and Spain has a large deficit). The euro area intra trade is very high. However euro, in spite of its huge success in Europe remains to be a regional currency. Euro has not overcome its self-imposed limits on usage and adoption moving beyond the boundaries, due to the maintenance of the ERM-II Exchange rate stability requirements and the Maastricht deficit, inflation and interest rate criteria. The share of dollars in global reserves stands almost thrice of the euro.
The power of "incumbency" is conferred by the "network-externalities" that accrue to the currency that is dominant. Together these factors make it unlikely there will be a large or abrupt change in the dollar's reserve currency status. The sheer magnitude of dollar assets in the official reserves of foreign central banks and the realistic prospect of continued, and perhaps disorderly, depreciation of the dollar against most currencies, place central banks at considerable risk of incurring large capital losses on their dollar asset holding. With more than enough dollar reserves to meet liquidity needs, prudent asset management would seem to dictate some diversification away from the dollar and toward the euro.
The only reason why the Dollar hasn’t collapsed completely is because economies largely continue to recycle their surplus wealth and trade surpluses back into dollar-denominated assets. One columnist connects the dots with regard to the forex implications: “Less Chinese intervention to prevent renminbi strength would mean China, slowly over time, would build up fewer dollar reserves.” In other words, economies no longer concerned with pegging their currencies would have very little reason to build up large pools of reserves.
We all are entitled to our opinions, but not to our facts. So let’s get the facts right before we fell into the folly of stumbling to forecasting. As much as 70 percent of the world’s currency reserves are held in dollars, according to the IMF, leading to calls for nations to diversify their cash piles to avoid excessive exposure to the U.S. economy as it quadruples its budget deficit in a bid to counter the worst recession since the Great Depression. To quote the Economist “It is hard to think of a parallel in history. A country heavily in debt to foreigners, with a government deficit it is making little effort to control, is creating vast amounts of additional currency. Yet it is allowed to get away with very low interest rates. Eventually such an arrangement must surely break down and a new currency system will come into being, just as Bretton Woods emerged into the 1940’s.” Cost of an abrupt switch over from dollar to other reserve currency is prohibitively high. Its replacement as the reserve currency of central banks would be slow and painful process. As IMF chief Mr. Kahn said about a new global currency based on SDR “it is not going to happen tomorrow, but it may happen in 10 years.” The replacement seems imminent. When and which currency is a question which only time would tell.
“My greatest challenge has been to change the mindset of people. Mindsets play strange tricks on us. We see things the way our minds have instructed our eyes to see”— Prophet Muhammad[/i]